The end of “risk-on/risk-off”

Anwiti Bahuguna, Ph.D., Senior Portfolio Manager | February 3, 2014

  • The recent decline in cross-asset correlations may offer better investment opportunities for active managers
  • Lowering both cross-asset correlations and inter-asset correlations provides potential benefits for structuring multi-asset portfolios
  • Active managers should seek non-traditional diversifiers of portfolio performance and remain flexible

A notable event of 2013 was the remarkable decline in cross-asset correlations implying potentially better investment opportunities for active managers. After the financial crisis, cross-asset correlations rose sharply as asset prices reacted predominantly to macro factors and less to individual stock or bond characteristics. For example, while the correlation between equities and commodities used to be negative or very low, it rose to over 80% during the crisis years (2008-2011). Correlations between equities in different regions (emerging markets (EM) vs. developed markets (DM)) used to be low, but also rose to over 80% during this same period, reducing the benefits of cross-regional diversification. Similarly, correlation between equities and high yielding bonds rose from about 50% to over 80%. When investors took risk, most assets rallied with the exception of sovereign bonds. Conversely, when risk sold off, only sovereign bonds had positive returns. This risk-on/risk-off regime posed a problem for multi-asset portfolios as many of the traditional diversifiers of equities increasingly behaved much more like equities, making it harder to achieve portfolio diversification.


Source: Columbia Management Investment Advisers, LLC, December 2013

Correlations between equities, credit, foreign exchange, interest rates and commodities have steadily increased over the past two decades. As you can see from the chart below, taking a simple average of these cross asset correlations shows that correlations were mostly in a narrow range up until 2008 and then began to rise sharply. Last year, these correlations fell significantly to the upper end of that long-term band. This move could potentially signal the end of the risk-on/risk-off regime. It is also important to note that we have witnessed a decline in inter-asset class correlations as evidenced by the decline in the correlation of stocks within the S&P 500 Index.


Source: Columbia Management Investment Advisers, LLC, December 2013

Lowering both cross-asset correlations and inter-asset correlations provides potential benefits for structuring multi-asset portfolios. First, as the correlation of stocks within the S&P 500 has declined from the peak reached in 2011 to more normal levels, it makes active strategies potentially more attractive. Second, cross-regional correlations have fallen due to the divergence in performance of DM equities (particularly U.S. and Japan) and EM equities. Recent growth worries in EM have led to significant underperformance in a period where most DM are stabilizing. Identifying structurally sound countries has always been an important component of successful EM investing, but it is critical in today’s environment.

Commodities are another traditionally important portfolio diversifier, whose correlation to equities has historically been very low. However, in the post crisis period, their correlation to equities increased sharply and they became a risk-on/risk-off asset class as macro uncertainty meant potentially weaker growth and weak demand for commodities. While the commodity/equity correlation has diminished somewhat, commodities as an asset class remain sufficiently unattractive particularly when you take into account their much higher volatility.

Treasuries or government debt remains the only asset class with a reliably negative correlation to equities over the risk-on/risk-off regime. But in 2013, correlation between equities and bond returns unexpectedly turned positive calling into question the ongoing reliability of this relationship. As the Federal Reserve began discussing an end to their aggressive bond buying program, investors expected a rise in rates but also worried about the impact of this policy change on future growth. During this period, bonds and stocks became positively correlated and bonds temporarily lost their portfolio diversification credentials. Looking ahead, we expect rates to rise gradually on an improved growth outlook, and for equities to continue to outperform bonds and regain their negative correlations. However, if rates were to rise and growth doesn’t improve (stagflation), or investors become nervous about the impact of monetary policy on risk assets, the current positive correlation between bonds and stocks could persist.

Recently, in a striking reminder of the risk-on/risk-off regime, risk came roaring back with the sell-off in EM assets bleeding into the developed markets. Equities, commodities, credit spreads, EM assets and carry trade strategies all underperformed with only sovereign bonds rising. Admittedly, global financial markets have shown some stabilization in the last year, but it’s too early to call an end to the risk-off/risk-on regime. Markets are still very much driven by intervention from policymakers across the globe and remain tightly linked. What does this mean for multi-asset portfolios? While there are better opportunities for active management within asset classes and across regional equities, we must continue to unearth non-traditional diversifiers of portfolio performance and remain flexible in our investment strategy to the changing market dynamics.


Diversification does not assure a profit or protect against loss.

The Standard & Poor’s (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks.

Correlation is a statistical measure of how two securities move in relation to each other. Correlations are used in advanced portfolio management.



Anwiti Bahuguna

Ph.D., Senior Portfolio Manager
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